aisleEarlier this week, Blue Buffalo released its 2Q2017 financial results.  While the numbers are always interesting, analysts were looking for further clarity on the company’s FDM launch and its anticipated impact on full year results, as well as insights as to where the brand is migrating and how it might offset dilution associated with a multi-channel strategy.  In short, the quarterly results were only the appetizer and the FDM launch narrative the main course. Reactions from the call seem to fall squarely into two camps — satisfied or bewildered.  The stock was up 6.6% on the day, which tells you which camp Wall Street fell into, but off its high during the trading session.  The stock had been up a double digit percentage during the session.

The quantitative metrics made for a mixed bag.  The company delivered in line EPS despite a – 2.5% topline miss.  Management attributed the miss to inventory delevering at major pet specialty accounts.  Organic sales growth was +2.8% (+3.3% in dry and +0.7% in WTO) driven by +1.8% mix gain and +0.9% inflation.  Sell through was ~ 7% representing sequential growth over 1Q2017.  Notably pet superstore sell through declined ~ 6% versus sell-in and was down ~ 11% year-over-year.  In contrast ecommerce growth was robust leading to a total sell through growth rate of ~ 30% in the channel. Gross Margin was also up +235 bps year-over-year, driven by supply chain efficiencies and lower input costs.  This appeared to be +125 bps over consensus.  The company affirmed full year guidance for both top and bottom line. The long short is Wall Street likes earnings and in combination with margin gains, it was enough to look past the sale miss.  The narrative appeared something akin to the following — “We will make it up in FDM!”

Management elaborated on its FDM launch, stating the four retailers it has partnered with represent between 8% – 9% of the pet food market on a dollar basis.  This expands Blue Buffalo’s addressable market by ~ 20%.  The company’s products will now be available in an additional 6,000 doors. Given that FDM over indexes on cat and wet/treats, management believes this unlocks some potential for growth in WTO.  Based on some early looks at the product set in Publix, it appears FDM will be selling 25 lb. bags of Life Protection Formula for a price consistent with a 30 lb. bag on Chewy.com. Blue Buffalo is targeting a high single digits/low double digits share in its FDM accounts.  Said differently, they are targeting 8% – 10% share within the retailers that account for 8% – 9% share of the pet food market.

The most notable aspect of the call, was the fact that Blue Buffalo did not speak to PetSmart or Petco before announcing the launch, which had been in the works for close to a year.  Thus, there was no way for them to weigh the competitive response from their major pet specialty retail partners. Management’s response to analyst queries was akin to, “we are hoping for the best.”  Whether it was coincidental or contributory, PetSmart CEO, Michael Massey, resigned today (see press release here).  My sense is that Blue Buffalo did not want to alert these retailers ahead of their pending category resets.  This would have likely led to greater near term shelf losses as the superstores increase shelf space for their premium private label offerings.  Blue has demonstrated they understand the timing game and are playing it to their advantage.

And the pace of change for the pet industry keeps accelerating…

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change. While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

 

 

 

 

 

 

 

 

 

 

 

blue dogOver the past year, we have covered, at length, the transitional phase that the pet industry now finds itself in.  We have encouraged market participants to question everything they have come to know as the “status quo” for the industry and assess the likelihood that it will continue to prevail over the next three, six, twelve months and beyond.  For those who have dismissed the potential for wholesale industry change, we have pointed to the current political environment as a proxy, where the historical standard for how business gets done has descended into a state of entropy.  While the pet industry’s state of change has not reached the point of chaos, many traditional barriers have in fact fallen and are not likely to be seen again.

And another one goes…

Yesterday, Blue Buffalo began informing customers that it has begun distributing a subset of the BLUE Life Protection Formula (LFP) to select mass and grocery retailers.  Product will begin showing up on the shelves of Target, Kroger, Meijer, and Publix in August.  The company stated, “We have decided that broadening the distribution of LFP, our entry-level natural pet food line, is the natural evolution of our go-to-market strategy.”  The company intends to focus on smaller bag sizes and more mainstream formulations in its FDM solution set.  The company’s other lines will continue to be pet specialty exclusives.  See the full letter here.

To some this will come as a surprise.  After all, the pet industry has relied on well-maintained channel boundaries wherein brands choose to focus on and remain loyal to either pet specialty or FDM as a means of garnering retailer support.  Within these buckets there are soft boundaries between independent pet specialty and major pet specialty and between mass grocery and natural grocery.   When a big brand jumps the turnstile it is a BIG DEAL.  However, in this case it appeared to be inevitable.

When Blue Buffalo went public in 2015, pet superstores accounted for approximately 70% of the company’s revenue and was growing at over 7%.  Fast forward to 2017, and pet superstores are expected to account for less than 55% of total company sales and their growth rate will contract over 6%.  This trend line is not expected to change, with further contraction contemplated going forward.  To offset the challenges within its core channel, Blue Buffalo launched other growth initiatives focused on the veterinary channel and international markets. We viewed these as simply stop-gap measures while the company waited for the right time to make its move to mass.  That time has apparently arrived.  However, it arrived in a somewhat unanticipated way.  Our assumption was that the company would partner with Walmart, but instead it chose Target and conventional grocery.  This leads us to believe that a Walmart launch will be a 2019 event.  Blue Buffalo will wait until its Target and grocery channel account sales anniversary and then launch in other mass accounts, providing them four years of baked in growth optics based on mid-year launches.  That is public company behavior hard at work.  As of this writing the stock is down ~ 2% on the news, but don’t expect it to stay that way.

Now that Blue Buffalo has made its move, the question is what is the competitive response.  Just last week Champion Petfoods and Fromm Family Foods were showered with praise from independent retailers due to their willingness to move off Chewy.com in light of its acquisition by PetSmart.  Just a week later they now are faced with a different decision as they both could undoubtedly enjoy a national roll out at PetSmart, Petco, or both if they are willing to embrace that opportunity.  Other brands that are likely to benefit include Chewy’s own American Journey, which could easily transition to an online/offline brand.  Nulo is another prime candidate given its performance in PetSmart and the emergence of its Freestyle line in independent pet specialty.  Brands like Nulo, who effectively straddle the inner channel boundaries, are likely to welcome the news of a Blue FDM launch.

From a retailer perspective, one has to believe that Blue Buffalo shelf space will decline in the near term, if only as a psychological feel-good moment.  The pet specialty channel has a strong reliance on Blue Buffalo, so it’s ability to have a meaningful response is, to a large extent, muted.  Some back of the envelope math would suggest that nearly 25% of Petco and PetSmart food sales are in Blue Buffalo products.  The likely answer will be less retailer financed marketing support, though Blue Buffalo can take up that spend through national ad campaigns.  Notably, the company intends to begin tagging commercials for its pet specialty exclusive lines with “available at your favorite pet specialty store”.  Independents may have greater perceived influence by curtailing product recommendations, but that only works if they can effectively steer potential customers into alternative brands. Many retailers have found that converting Blue Buffalo customers is harder than it looks.

Finally, we come to the leading FDM brands.  It’s natural to assume that Freshpet, Rachel Ray, and I & Love & You should be concerned.  After all, there is only so much space available for the pet category within these retail environments.  However, each of these companies have forms of differentiation that they can rely on be it form factor or brand attributes, so Blue Buffalo’s ability to drive traffic to the channel may in fact benefit them as consumers begin to rethink the role of their grocery retailer in fulfilling a critical mass of their pet spend basket.

Every day, the pet industry looks less like a behavioral outlier, and more like its human industry peer group.  The change the industry has undergone over the past 12 months is dramatic, but a new end game is starting to come into focus.  That should excite companies with innovative products, salient marketing messages, and strong execution capabilities.  To the victor go the spoils.

ETA: PetSmart bond prices have declined almost 4% since the announcement.

petm

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change. While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

 

dylan“The times they are a-changin” – Bob Dylan

Industry analysis is easy when everything is moving up and to the right.  When market conditions are such that a rising tide does not float all boats, it is harder to draw conclusions that are applicable to a broad set of market participants.  The pet industry now finds itself in an operating environment where company execution will most likely determine the winners in this phase of the cycle.

The  pet industry has hit a transformative moment.  The humanization movement, though it continues to be cited regularly, has achieved its point of arrival — pets are treated like members of the family.  Kids today only know of pets as their equal.  As a result, there are no longer large cohorts of pet owners who are available to upgrade.  At the same time, younger generations now represent the largest segment of pet owners, and they think and act differently than their parents generations.  However, they also lack the same disposable financial resources, meaning they have to make tradeoffs today.

These realities are changing the power paradigm in the category.  The pet consumer is in the ascendancy at the expense of all others who participate in the supply chain.  Today the pet owner is able to choose among channels and brands based in their personal values.  Effectively product access has been commoditized. Consumers are now able to dictate to manufacturers what attributes they seek, not vice-versa.  In the future this paradigm will move across the sub-categories within in pets to redefine who wins and who gets left behind.

When market dynamics shift with significant force, it usually leads to elevated levels of industry consolidation. The 2015 – 2016 period was the greatest period of consolidation the industry has witnessed, and we expect that will continue.  With that as a backdrop, we present our pet industry capital market themes for the Spring of 2017:

  • Major Pet Specialty Franchises Struggling. It was not long ago that PetSmart and Petco could do no wrong. The major pet specialty chains were posting SSS comps that were the envy of retail analysts; the gap between the two biggest pet retailers and the balance of the industry seemed vast and unbridgeable. How quickly things can change. Over the past three years, major pet specialty has watched its franchise erode. Independent pet retailers out-serviced them; FDM retailers poached manufacturers and offered customers a better cost value proposition; and ecommerce providers out-priced and out-“convenienced” them. In 2016, we estimate that PetSmart comped down 3% – 4% (mature stores) and that Petco comps were flat to down 2% (mature stores). With their loan packages trading below par, both companies are under pressure to innovate. Petco’s turnaround strategy appears focused on private label and house brands.  PetSmart is focusing on ecommerce, as evidenced by its acquisition of Chewy. What is clear is that there is no silver bullet for what ails them. Expect things to get worse, before they get better as brands begin to feel pressure to find other sources of growth and as Petco and PetSmart refine their respective strategies.
  • Treat Acquisitions are Focused on Sustainable Competitive Advantage. The treat space has been actively consolidating as manufacturers compete for the discretionary portion of the pet owner’s shopping basket. However, what is rapidly changing is the attributes these consolidators are seeking in their acquisition targets. Deep customer relationships built through an emotive brand are now the table stakes.  Buyers want some form of competitive advantage that has greater barriers to justify prevailing multiples. The acquisition of Salix Animal Health (Spectrum Brands) and Whimzees (WellPet) are examples of this in practice. Other major pet treat IP players, including Petmatrix, are most likely to get snapped up by the large industry players. This will in turn create an opportunity for private equity to acquire mid-stage brands and invest in building these attributes.  The phrase “innovate or perish” has never been truer than in the treat space today.
  • Digital Pet Age Has Arrived. Historically, pet industry incumbents have been dismissive of the potential for category disruption through technology innovation. Major pet retailers were not well situated to sell the solution set; legacy pet ownership generations, the Baby Boomers, did not understand it; market leaders were not organized to innovate into the category. As a result, Chewy, A Place for Rover, Bark Box, Whistle, and their peers rose up to fill the market void, creating substantial shareholder value as pet ownership dynamics shifted to favor the digital generations. In 2016, $154 million dollars was invested in 46 pet-tech deals, a pace that has been increasing since 2012. Even in its nascency the pet tech movement is showing signs of making a lasting impact. As Millennials further outpace Baby Boomers in terms of pet ownership, digital will gain more momentum in the pet category. This realization will leave strategic buyers who have not made a tech play scrambling to play catch-up.  This trend augers well for acquisition valuations in this sector of the market.
  • Expect M&A Transaction Velocity to Remain High. Since 2014, transaction bias in the pet industry has been towards M&A. 2015 – 2016 was the greatest period of industry consolidation as measured by transaction volume. As company’s reposition themselves to compete in a rapidly changing landscape, we expect elevated M&A activity to continue in 2017. Market leaders will seek to plug remaining portfolio gaps while small and midsized players will be looking to exit at the tail end of the cycle. While acquisitions may be plentiful, there will also be a flight to quality with differentiated assets – brand, scale, channel (direct or proprietary) – garnering premium valuations, while those lacking it face commodity multiples. If the U.S. implements tax reform, volume should spike across asset classes providing private equity a unique opportunity to buy into the category.  Financial buyers will be banking on these assets to carry them through the next recession.

As always, our full pet industry report is available by request.

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change. While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

blue dog 2Over the past five years, interest in the potential and performance of the online channel for pet products has become an increasingly hot topic.  The narrative around pet ecommerce has been fueled, in part, by a change in ownership demographics, but more significantly by the lack of transparent data regarding the size of and growth rate in the channel.  Quite simply, no one knows how much pet food is sold online or how fast the channel is actually growing, and therefore everyone is free to speculate.  The loss of PetSmart as a public reporting entity only further exacerbated this reality.

What we have known for some time is that online is taking share and its growth is a key driver of malaise within major pet specialty.  Whether you source your information from Packaged Facts, IBISWorld, or Euromonitor, all three entities have online pet products sales in the U.S. growing at between 10% – 15%.  Further, according to Packaged Facts 2016 National Pet Owner Survey, 46% of pet owners buy products online, an increase of 5% from 2015. Thus, the intent from a consumer perspective continues to rise.  Additionally, Blue Buffalo, widely believed to be the top selling pet food brand online, CEO Billy Bishop commented, in the company’s most recent earnings call, that the shift to online is occurring much faster than anyone at Blue Buffalo anticipated.  Couple this with the fact that during FY16, Blue Buffalo’s share of sales outside of major pet specialty increased from 33% in Q1 to 41% by Q4 primarily behind the sharp increase in ecommerce.

No entity has been more responsible for shaking up the pet retail world than Chewy.com.  In November 2016, we got our first real glimpse into the organization when a Bloomberg article detailed that the company anticipated that it would generate $880 million in sales for the calendar year.  Further, it projected 70% growth in 2017, bringing the company’s topline to $1.5 billion.  A recent Miami Herald article pushed that number to $2 billion. According to a recent survey by 1010data, Chewy.com has approximately 51% share of the online pet products market including autoship revenues.  This contrasts with Amazon at 35%, also inclusive of autoship.  Chewy also leads in subscription pet food sales at 10.2% versus 7.6% for Amazon.  PetSmart garners 7.9% of the market when you consolidate its own banner (2.2%) with sales of its Pet360 (5.7%) acquisition.  Petco clocks in at 3.1%, while Wal Mart (< 1%) barely registers. Finally, Chewy employs 200 full time portrait artists who churn out 700 oil paintings a week for unsuspecting customers.

Chewy, which has never turned a profit and has been funded by $261 million of equity, raised over five rounds, and $90 million of debt, is in the process of upping the table stakes.  The company recently launched its American Journey house brand of dry kibble.  American Journey, which comes in seven flavors, currently costs $39.99 for a 25-lb. bag before autoship discount.  This is $8 – $10 less than a comparable sized bag of Blue Buffalo on the site.  Notably, American Journey is made by one of Blue Buffalo’s co-packers. Additionally, Chewy launched Tylee’s, their human grade fresh/frozen pet food brand aimed squarely at the increasing band of upstarts seeking to deliver human meal equivalents for your pet. The company is also said to be working on a public offering slated for 2018.

The question of whether Chewy.com can be stopped has been answered. It’s most recent financings ($75 million of equity from BlackRock and $90 million in debt from Wells Fargo) suggest that investors are looking past the profitability profile and instead focusing on the growth history and the potential IPO valuation.  Mutual funds targeting a pre-IPO stake are likely accessible should the company need additional funding. The more intriguing question is whether there is a transaction alternative that might be more attractive to Chewy shareholders than a public offering.  As Chewy.com Chairman Mark Vadon, who co-founded Zulily, can attest, being a public company without earnings is not all that it is cracked up to be.  We rule out an Amazon combination for a myriad of reasons.  This leads us to Petco or PetSmart as the most logical destination.  While somewhat counter-intuitive on the surface, if Chewy.com could extract more value in a combination than an IPO, why not consider it?  Given the weak comps we have been hearing coming out of Petco and PetSmart, a combination with Chewy.com would solve a myriad of problems.  Chewy would gain access to cash flow and hundreds of local warehouses, while Petco or PetSmart would be able to rationalize its store base and gain the pole position in pet omni-channel.  It might not be as far-fetched as we think.

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change. While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

 

 

rx

I recently had the opportunity to speak at the First Annual Pet Food Investor Forum, sponsored by Susquehanna  Financial Group. The conference was primarily geared towards public equity analysts and it was interesting to see this class of market observers collectively hone in on a few key questions that were affecting the public equities in the pet food sector. Among those questions, one that came up with the greatest frequency was the prospects for Blue Buffalo to penetrate the veterinary channel.  The array of speakers were almost universally asked to proffer our views on this issue, as it is central to the next leg of the Blue Buffalo growth story.

Since Blue Buffalo announced its intentions in the professional channel, I’ve held the belief that it was likely going to struggle to gain penetration quickly. My view was grounded on two basic premises, neither of which speaks to the quality of their solution set, of which I have no knowledge.  The first is that this channel has some very strong incumbents, who have a long history with the channel and its practitioners. The vets I have spoken to suggest that is going to be hard to overcome given how hard it is to create access. Second, was that building sales in the veterinary channel takes time and requires fundamental research that Blue Buffalo might have a hard time producing quickly, unless they had started this process long before the commercialization efforts came to light. Blue has obviously overcome significant hurdles in its history to become a near $5 billion market cap company, and there is reason to believe that if you give them a long enough time horizon that they will make inroads. I only see it as a question of magnitude.

However, last week something caused me to begin to rethink my paradigm.  Lawyers in the State of California, on behalf of California, Minnesota, Georgia, and North Carolina filed a class action lawsuit against the major players in prescription pet food (Mars, Nestle, Hills) and a subset of their primary distributors of their prescription products (Banfield, BluePearl Vet, PetSmart).  The lawsuit contends, among other things, the following, (a) there is nothing unique in the ingredient deck of prescription pet food to differentiate it from non-prescription pet food, (b) the marketing, labeling and sale of these products is deceptive, and (c) the defendants are engaged in anti-competitive practices to sell these solutions at above market prices to consumers.  If you want to read the full complaint it is here.

While I am not a lawyer or a Holiday Inn Express customer, at first blush, it would appear this case is good for Blue Buffalo’s potential franchise in the veterinary channel.  If the plaintiffs were to win their case, it would likely open up the channel to competition, giving Blue Buffalo a seat at the table. Further, if successful, the case could erode the brands of incumbent players in channel, driving faster penetration and sales of Blue Buffalo’s prescription solutions through consumer requests. That said, Blue Buffalo would also have to deal with any implications of the lawsuit given it operates in the category. However, when one digs deeper, it becomes apparent that this case is far from a done deal.

Let’s first deal with the issue as to whether prescription diets should be allowed to be labelled as such.  It is correct that prescription pet food diets do not contain controlled substances and are not manufactured under purview of the FDA. However, they are formulated for specific conditions and feeding them to an otherwise healthy pet is likely, over time, to have consequences. This is what allows the manufacturers to call them “prescription”.  This is merely a labeling issue, and if changed would not make feeding them under general conditions advisable. Further, I don’t think this makes them deceptive by definition. The marketing of these solutions generally indicates they were formulated to specifically treat a condition, not that they contain a drug. These products recommend you only feed them under the supervision of a veterinarian, in case they don’t address an issue that needs addressing or there are negative side effects of feeding them. Personally, I don’t see how labeling them prescription harms consumers and in fact the prescription protocol is, in most cases, necessary to protect pets from self-diagnosis by their owner and improper application. That all being said, these products could be labeled differently and if we adhere to a standard that the label prescription only covers controlled substances a change should be made. Whether that impacts anything beyond that does not, on the surface appear to be all that damaging.

The question of whether they are “different” is where things start to get muddy.  What defines a prescription diet is the inclusion of certain vitamins and minerals that are scientifically proven to help address a specific condition — kidney, cancer, obesity, skin, digestive, etc. The claim that these ingredients could be found in other pet food products sold without a prescription does not make them the same. The notion that pet food is pet food because all of the ingredients are generally available does not hold water in my view. If it did, pet food would only be sold in flavors, formulations and brands would not matter. I suspect lawyers from the manufactures cited in the cause of action have parsed these issues for their clients many times. We also know that brands matter in this category, Blue Buffalo’s success being a prime example of that.

Finally, I can’t speak to anti-competitive behavior, as I don’t know what goes on behind the scenes, but the pricing claims make me smile.  The cost of pet food has escalated significantly post-recession (40% on average on a per pound basis since 2011 according to GfK) without much of a peep from lawyers, despite the fact that class action lawsuits in the pet category have escalated significantly.  The prices of of most Hill’s Prescription Diet dry dog food solutions in 25 lb. bags runs between $80 – $85 online, approximately $3.25/lb.  This translates to approximately $2.40 per 1,000 calories, while higher than premium kibble at $1.75 – $2.25, this is significantly less than dehydrated ($5 – $8), premium cans ($7.5 – $10), frozen raw ($10 – $11) and premium freeze dried ($11 – $18).  If there is outrage around the price, it should be kept in context. When combined with the notion that these solutions are in fact different, these claims lose some of their veracity.  For me, you would have to believe that the veterinarians are coercing their clients into buying these solutions because they have no other choice and then providing them no other means of access than to pay the price for which they are selling them. However, these solutions are available online and transactions are facilitated through prescription verification providers such as Vetsource.  This feels much like a contact lens parallel.  Are there drugs in contact lens? Ponder that.

The net of all this is that it will spur dialog about labeling of these solution sets, and consumers who have purchased these products may end up with coupon books or rebates from manufacturers, but I don’t see that as providing a meaningful recasting of the competitive landscape for the prescription pet food.  And while Blue Buffalo should be a beneficiary in the near term, it is unlikely this provides them the runway they need to rapidly penetrate the channel.

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change.  While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

thAnxiety about ecommerce in the pet industry is not a new phenomenon.  I’ve had it for a while; it seems to come in waves.  Often the “worry” is overcome through the most limited acceptable response from a market participant, just sufficient enough to satisfy my concerns. Most recently, my unease related to the future of Chewy.com, the leading independent ecommerce player in the industry.  My fear was that should Chewy be cut off from the capital markets, it could lead to a meltdown given its operating profile and cash burn, setting the online component of the industry back for a decade, from which it may not recover.  Thankfully, for the moment, my concern has been assuaged with the announcement of the company’s most recent funding, a $75 million investment from investment management firm Blackrock.

Pet ecommerce is a bit of an enigma, wrapped inside a riddle, wrapped inside a conundrum.  The conundrum — the perceived potential for cannibalization of four wall retail revenue — started it all in my opinion (others will quibble here, but to do so would merely be a digression).  For years, Petco and PetSmart buried their head in the sand about the potential for ecommerce in the pet industry. As the dominant retailers in the category, their view was akin to “why promote it, if you don’t want it to happen?”. The number three and four retail players possess a limited to non-existent ecommerce capability set as well.  The riddle was how to get a 25 – 40 lb. bag of dog food to a customer’s door without going broke in the process.  The failures of those who tried to solve the riddle, before the needs of customers were sufficient to want it or the infrastructure was available to make it happen, only served to reinforce the conundrum.  The cost problem has been addressed in a variety of ways ranging from infrastructure partnerships, to rising consumer demand, to subscription services, to more effective cross selling of higher margin products to online consumers.  The enigma remains how much ecommerce is influencing the pet industry and the trajectory of its largest retail players.

Depending on what you believe, online sales of pet products accounts for 6% – 10% of industry sales, or $4 – $6 billion.  Again, depending on your source, online sales for pet products is growing at 12% – 20% and enjoys the highest sales penetration of any home care category in the U.S.  However, the U.S. trails both the UK and China in terms of sales penetration of pet food online.  Of these estimated sales, we now know Chewy.com makes up $880 million of them, according to a Bloomberg article where the notoriously secret company disclosed details of it’s most recent funding, a $75 million equity financing from Blackrock.

To date, Chewy.com has raised $236 million (or $248 million depending on your source) in equity from a variety of institutional investors.  There is no complete data source that can reconcile that number — mapping the who, the when, and the how much.  However, we do know investors have migrated from traditional venture capitalist (Volition Capital and Greenspring Associates) to mutual funds whose investments often are a precursor to an IPO (T. Rowe Price and Blackrock). These fund have been necessary to fuel the company’s hyper growth, which has been driven by aggressive customer acquisition and rock bottom pricing for customers.  You don’t go from $0 to $880 million in online revenue in five years without a significant war chest and a willingness to buy customers at essentially whatever cost is required

However, on the way to becoming a pet industry unicorn, Chewy.com’s world began to morph.  First, Jet.com added the category and began to compete aggressively for customers driving up acquisition costs for all the major players and driving down profits for price matching entities as Jet sought to undercut the market when possible. With Jet’s acquisition by Wal-Mart, this issue may abate over time in the name of its parent company’s earnings and ROI requirements. Second, the major physical retailers began to quietly fight back, threatening punitive action for brands that would not enforce MAP online.  While MAP would be a net positive of Chewy’s margin profile, it would likely have come at the cost of growth, a necessity to access the capital markets.  Finally, was the issue of the most recent election cycle.  As Chewy sought to fund its business it was likely going to be pushed towards foreign markets or an IPO, as a trade sale at an attractive price appears unlikely unless you view the business as a capability acquisition and not a category play. Based on the trade and capital markets forecasts for the incoming political regime, there are concerns about slowing foreign investment in U.S. companies against a back drop of changing trade policies and the potential for the IPO window to close as a result of a market contraction.  While neither of these may come to pass, the concerns are real.  This makes the most recent announcement by Chewy to be welcome news, in my opinion, for all independent pet ecommerce players.

Should the public capital markets continue to be inviting, expect an S-1 sometime in 2017 for Chewy.com.  Further, cross off another of our anticipated transitional events for the pet industry in 2016 – 2017 (see here).

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change.  While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

 

skyThe pet industry continues to work through a series of fundamental issues — demographics, channel shift, brand attributes — that, over time, are expected to reshape the competitive landscape.  While fundamentals are favorable — consumption, consumer confidence, employment, real wages, housing — these tailwinds are not sufficient to float all boats.  When the market bifurcates into “leader” vs. “laggard”, and the historical leaders now find themselves playing catch-up, you get dynamic market shifts.  While there are signs of a transition in process, this cycle is only now gaining momentum, and inertia will take some time.  In the interim, here are the key trends we are keeping an eye on over the forward six months:

  • Growth On Pace for Anticipated Uptick.  The pet industry experienced a relative malaise in 2015, with industry growth, as measured by APPA figures, slowing to 3.8%, despite a 0.3% uptick in performance of the food category, the largest component of pet spend (~38%), to 3.5%. Based on macro indications the industry appears on pace to exceed projected 2016 growth of 4.3%, driven by an acceleration in consumables.  That said, a rising tide is not lifting all boats. Growth is manifesting itself in a much more pronounced way, from a percentage standpoint, among independent retailers and brands, from brands that have managed the digital migration of their message and products effectively, and from brands that rely on or incorporate alternative form factors. Growth, in isolation, masks a myriad of problems. Large retailers and major pet food marketers risk further erosion of their franchises if they don’t adapt more quickly to emerging ownership and channel realities.
  • Industry Working Through Transitionary State. The foundation of our Spring 2016 report was the observation that the industry was undergoing a restructuring, and would remain that way throughout 2017. This restructuring involves tactical changes to embrace evolving ownership demographics and consumer behavior patterns. We are seeing signs that many key players are in fact moving to action. A number of larger manufacturers are actively working through their digital strategies and assessing how they develop both ecommerce and customer analytics capabilities. Mid-sized box chains and distributors are evaluating alternatives for addressing online gaps. Several key pet specialty brands appear poised to move to FDM. Finally, online retailers and large distributors seem to be headed towards a convergence. While not all the key transitory events identified are in play, the industry is shifting before our eyes. These changes should drive increased M&A activity.
  • Small Box World is Consolidating.  The rise of the independent pet channel has been one of the greatest value creators for the pet industry post-recession. Growth in small box and mid-sized chains has paid significant dividends for the brands that cater to them, the distributors that serve them, and the owners of the most professionalized operations. This channel is viewed as the champion of the consumer, providing them with education and advice and, as a result, has attracted a slew of authentic brands seeking to monetize this connection. Now the channel is consolidating. While acquisitions by Tractor Supply, Pet Supplies Plus, and Pet Valu are most notable, so to is the external communication from companies like Chuck & Don’s and Bentley’s Pet Stuff that they are seeking acquisition opportunities. Many chains will have to choose whether to participate in this race for scale and geographic expansion, or temper their growth expectations.  Long term, omnicannel will win in both broader retail and pet.  However, to develop these capabilities a certain scale is required in order to justify the investment.
  • Deal Volume Increases but Not Realized Outcomes. When industries undergo evolution, transaction velocity predictably increases as companies try to reposition themselves for the next growth cycle. This phase began in 2H2014 when pet industry M&A activity spiked and continued through the record year of 2015.  While we continue to see elevated levels of market activity in 2016, it has yet to translate into a pace of closed deals that would match the prior year period, making it likely 2016 will be a down year for closed deals.  The reasons for this are multi-faceted. First, when large strategic buyers are working through their own portfolio issues they tend to prioritize their current brands at the expense of M&A. Second, as buyers step further out of their comfort zone, they tend to be more price sensitive. Finally, a number of buyers continue to digest their acquisitions from 2015, making them less aggressive on the M&A front. Couple this with continued high valuation expectations on the part of lower middle market sellers and you end up with more failed sale processes.

As always, a complete copy of our 2H2016 industry report is available by email.

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change.  While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.